Capitol Hill’s holiday cheer boosts the dollar

The dollar is extending gains today as the fundamental back-drop improves in the US. The dollar recovery was initially spurred by the better than expected November retail sales data, which has triggered hopes that personal consumption can pick up at the end of the year after falling to a two year low in Q3. Secondly, the House of Representatives overwhelmingly passed a bi-partisan budget bill last night that would set spending limits for the next 2 years.

Republicans and Democrats do their jobs

The key word in the above sentence is bi-partisan. Yes, Republicans and Democrats have adopted the festive spirit and let bygones be bygones and managed to agree on a Budget two months in advance. It seems that Congress has learned its lesson after October’s 3-week government shut down and the near-miss with a default. Republicans and Democrats have been squirreled away working on this deal with little fanfare in the last 6 weeks, this wasn’t what the market expected, hence the sharp reaction in the dollar in the last 24 hours.

A Debt ceiling deal now looks possible

The most unexpected part of the House vote was Republican leader of the House John Boehner openly dismissing and chastising the extreme wings of his party. Tea Party folks haven’t got their way this time; it will be interesting to see how they retaliate next year. Of course, the debt ceiling still needs to be raised in early 2014, but surely if both sides can work together on a budget plan then raising the debt ceiling by a few hundred billion will be a doddle?

Will Bernanke take the plunge?

So what does this new flourish of bi-partisanship mean for the markets? It is one less hurdle for the Fed to negotiate before tapering its QE programme. The market is now rushing to price in a potential Dec-taper at the FOMC’s meeting next week. This didn’t seem possible a week ago, in the past the Fed has tried to paper over the political cracks (or chasms) with liquidity. Now the market is starting to think that it could be possible for Bernanke to taper next week during his penultimate meeting as Chairman. He will chair his final meeting in January before Janet Yellen takes the lead for the March meeting. If the Fed does embark on a taper next week then Bernanke will still be in the building to clean up any mess it may cause, which is the honourable thing to do rather than taper in January and leave your successor to deal with the consequences.

As the market prepares for a potential tapering next week, the dollar index has rallied off recent lows and is testing a key resistance zone at 80.30-35 – the base of the daily Ichimoku cloud and the 50-day sma. A weekly close above this level would be a bullish development that could open the way to 80.80-85 – the 100-day sma and the top of the daily Ichimoku cloud (see chart below).

Changing the market’s psyche

Interestingly, stock futures are pointing to a positive open for US markets, so will stocks be hurt by fears of Fed tapering? As we mentioned earlier this week, that will depend on whether tapering = tightening in the market’s psyche. So far it appears that this link may have been broken. Interest rate expectations, according to the forward OIS swaps curve, are still looking for the first rate rise in Autumn 2015, so interest rate expectations have not been brought forward even though the prospect of the Fed embarking on its tapering programme next week have been rising. Since equity markets tend to dislike tighter monetary conditions, this means that stocks may be able to rally even if the Fed does start to scale down its asset purchases at its next meeting.

Thus, we can thank the politicians in Washington for making the last full week before the holidays potentially extremely interesting.